a) Explain what would affect the effectiveness of fiscal policy as a measure to reduce a country’s unemployment rate. [10]

There are two main strategies for reducing unemployment

  • Demand side policies to reduce demand-deficient unemployment (unemployment caused by recession)
  • Supply side policies to reduce structural unemployment / (the natural rate of unemployment)

Demand Side Policies

Demand side policies are important when there is a recession and rise in cyclical unemployment. (e.g. after 1991 recession and after 2008 recession)

1. Fiscal Policy

Fiscal policy can decrease unemployment by helping to increase aggregate demand and the rate of economic growth. The government will need to pursue expansionary fiscal policy; this involves cutting taxes and increasing government spending. Lower taxes increase disposable income and therefore help to increase consumption, leading to higher aggregate demand (AD).

With an increase in AD, there will be an increase in Real GDP (as long as there is spare capacity in the economy.) If firms produce more, there will be an increase in demand for workers and therefore lower demand-deficient unemployment. Also, with higher aggregate demand and strong economic growth, fewer firms will go bankrupt meaning fewer job losses.

In a recession, resources (both capital and labour) are idle, therefore the government should intervene and create additional demand to reduce unemployment.

 

Impact of Higher AD on Economy

AD-increase

However,

  1. It depends on other components of AD. e.g. if confidence is low, cutting taxes may not increase consumer spending because people prefer to save. Also, people may not spend tax cuts, if they will soon be reversed.
  2. Fiscal policy may have time lags. E.g. a decision to increase government spending may take a long time to have an effect on increasing AD.
  3. If the economy is close to full capacity an increase in AD will only cause inflation. Expansionary fiscal policy will only reduce unemployment if there is an output gap.
  4. Expansionary fiscal policy will require higher government borrowing – this may not be possible for countries with high levels of debt, and rising bond yields.
  5. In the long run expansionary fiscal policy may cause crowding out, i.e. the government increase spending but because they borrow from private sector, they have less to spend and therefore AD doesn’t increase. However, Keynesians argue crowding out will not occur in a liquidity trap.

 

b) Although the Singapore Government remains cautious of deficit-spending, most governments see it as an acceptable way to reduce unemployment rates. Discuss whether a government should pursue full employment at all costs. [15]

Intro

The main macro economic objectives of the government will include: low inflation, increasing the sustainable growth rate, full employment and balance of payments equilibrium.

Full employment involves zero or very low unemployment. In practice there will always be some frictional unemployment as people are looking for new jobs or leaving school. Economists suggest an unemployment rate of 3% is close to full employment. However, it is difficult to determine precisely. Full employment implies the macro economy is operating at its full capacity and there is no output gap or demand deficient unemployment.

Thesis

The main reason for targeting full employment is because, high unemployment has various social and economic costs. Firstly, the unemployed will have low income enabling little consumption. Also, the unemployed may become de-motivated and de-skilled. This makes it more difficult to find employment in the future. Also, during periods of high unemployment, the government will have to spend more on unemployment benefits, which will increase government borrowing. Finally, unemployment may exacerbate social problems such as crime, vandalism and social alienation, especially if unemployment is concentrated amongst young people.

Other Positive effects of full employment

  • Maximising potential output in an economy, achieving productive efficiency and economic growth
  • Reduces inequality and prevents relative poverty from those who are unemployed.
  • Full employment will improve business and consumer confidence which will encourage higher growth in the long-term.
  • Unemployment is a big cause of poverty, stress and social problems.
  • Full employment reduces government welfare spending and enables more income taxes – improving budget position

Score Point Example – Great recession and criticism of ECB

During the great recession of 2008-13, it is a valid criticism that Central Banks like the ECB, placed too little emphasis on reducing unemployment in Europe. They placed too much emphasis on low inflation and deficit reduction, ignoring the much bigger social problem of unemployment.

Therefore, given the costs of unemployment, there are many social benefits to achieving full employment.

To achieve full employment, Keynesians will argue that it is necessary to increase AD when the economy is in a recession.

AD-increase

 

This can be achieved by loose fiscal or monetary policy e.g. lower interest rates.  Increasing AD may cause inflation to increase, but if there is spare capacity there should only be a limited increase in inflation. Therefore, there is a strong case for aiming for full employment through demand management (either fiscal or monetary policy)

Anti-Thesis

  • Full employment may cause labour shortages and wage inflation. This can lead to ordinary inflation.
  • Attempting to achieve full employment could lead to a boom and bust economic cycle. If growth is above the long run trend rate, the growth will be unsustainable.

The Phillips curve suggests there is a trade off between inflation. Therefore, achieving full employment may cause a side effect of inflation.

phillipscurve

Not all economists agree that full employment should be the primary objective They argue that unemployment cannot be reduced below the natural rate of unemployment without causing inflation. Also, any reduction in unemployment below the natural rate, due to demand side policies, will be just a temporary. This is because the economy will return to the equilibrium level of output.

monetarist

Therefore, Monetarists don’t believe there is any point in reducing unemployment below the natural rate because the only effect will be to increase inflation. Therefore, according to Monetarists attempts to achieve ‘full employment’ of 3% may conflict with other macro economic objectives, such as higher inflation. Many Western economies have an inflation target as the primary objective of their Central Bank. (e.g. ECB inflation target = 2%) The argument is that if low inflation is achieved, it will enable economic stability and encourage investment and sustainable growth in the long term. This is preferable to a government using demand side policies and causing boom and bust cycles

However, another way of aiming for full employment is to use supply side policies to try and reduce the natural rate of unemployment. For example, better education can improve the skills of workers and therefore reduce structural unemployment. However, these policies will take time and it may not be possible for the government to reduce all supply side unemployment.

Low unemployment can also be achieved through keeping inflation low and maintaining steady and sustainable growth. However, this may prove more difficult if there was an adverse shock to the economy.

Overall low unemployment is a desirable objective, but the policies to achieve this need careful examination. Increasing AD will only be effective if there is a recession and spare capacity. To reduce the natural rate, supply side policies will be needed.

Evaluation

Full employment doesn’t necessarily have to be inflationary. If the growth is sustainable, we could get close to full employment without inflationary pressures. It depends on the skills of the workforce. If there are big labour shortages in skilled labour, full employment could lead to shortages of labour.